2.3 Types of Main Markets and Market Participants

Section 2.2 looked at venues. This section looks at what is traded and who trades it. You should be able to identify each market type, the instruments it trades and the participants who operate in it.

Money Markets

Money markets trade short-dated debt instruments with original maturities of up to one year. They are the working-capital market of the financial system.

The Bank of England's sterling monetary framework operates in money markets: the Bank supplies reserves to banks via short-term repos, sets Bank Rate (the official policy rate) and uses open-market operations to keep overnight rates close to SONIA (the Sterling Overnight Index Average). Money-market rates are the foundation for the pricing of mortgages, savings and many derivatives.

Capital Markets

Capital markets trade long-term debt and equity — instruments with maturities over one year and shares with no fixed maturity.

• Gilts are UK government bonds issued by the DMO. They are the risk-free benchmark for sterling interest rates.
• Corporate bonds are debt issued by companies, typically 3–30 years, with credit risk priced as a spread over gilts.
• Equities are shares in listed companies traded on the LSE. They confer ownership rights (voting, dividends) and unlimited upside, against the risk of capital loss.

Capital markets fund long-term investment — government infrastructure, corporate expansion, homeowner borrowing via mortgage-backed securities — and they price long-term risk.

Derivatives Markets

Derivatives are contracts whose value derives from an underlying asset, index or rate. The main types are:

• Futures — exchange-traded contracts to buy or sell at a future date at a price set today (e.g. ICE Brent crude futures).
• Options — the right, but not the obligation, to buy (call) or sell (put) at a strike price.
• Swaps — agreements to exchange cash flows, most commonly interest-rate swaps (fixed for floating) used by UK banks to hedge mortgage books.
• Forwards — bespoke, OTC versions of futures, used in FX and commodities.

Derivatives are used to hedge (a UK exporter locking in a euro-sterling rate) or to speculate (a fund taking a directional view without owning the underlying). They can create leverage and contagion, which is why they are regulated and centrally cleared where possible.

Foreign Exchange Markets

FX markets exchange currencies. London is the world's largest FX centre, handling roughly 40% of global turnover. The spot market settles in T+2; forwards and swaps allow hedging of future flows. The Bank of England publishes daily London fixings. FX is largely wholesale and lightly regulated, though conduct standards (the FX Global Code) apply.

Commodity Markets

Commodity markets trade physical and forward contracts in metals (LME), energy (ICE Brent crude, natural gas), soft commodities (cocoa, coffee, sugar) and agricultural products. They allow producers (miners, oil majors, farmers) to hedge price risk and consumers (airlines, manufacturers) to lock in input costs.

Market Participants

The main participants in UK markets each play a distinct role:

Central counterparty (CCP) clearing

A clearing house such as LCH, CC&G (Cassa di Compensazione e Garanzia, an LCH Group subsidiary) or ICE Clear Europe interposes itself between buyer and seller. After a trade, the CCP becomes the buyer to every seller and the seller to every buyer. Each counterparty now faces the CCP, not each other, which dramatically reduces counterparty risk. The cost is that the CCP itself becomes a systemically important single point of failure, which is why CCPs are supervised by the Bank of England under the Financial Market Infrastructure Supervision regime.

graph LR
    A["Buyer"] -->|Trade| B["Seller"]
    A -->|Novation| CCP["Clearing House (CCP)"]
    B -->|Novation| CCP
    CCP -.->|Margin & default fund| A
    CCP -.->|Margin & default fund| B

Putting It Together

A retail client buying a Stocks and Shares ISA invests via a broker, whose order is routed to the LSE, where a market maker supplies liquidity. The trade is settled through a clearing house and a custodian. The client's cash was itself a bank deposit at a bank, used (via intermediation) to fund mortgages and business loans. Each participant in this chain performs one of the market functions from section 2.1.

Key Takeaways for the Exam

• Money markets: short-term debt (Treasury bills, CDs, repos, commercial paper), used for liquidity management.
• Capital markets: long-term debt and equity, used for investment funding.
• Derivatives transfer risk and create leverage; central clearing reduces counterparty risk but concentrates systemic risk in CCPs.
• London is the world's largest FX centre by turnover.
• Market participants: banks, building societies, insurers, fund managers, brokers, market makers, clearing houses — each with a defined economic role.